Sunday, September 26, 2010

Alan Greenspan: Ideology over reality 24

Greenspan made a clean, straightforward error.  First, here is some background.

Greenspan was born in 1926 in the Washington Heights area of New York City. His family was Jewish, with Herbert Greenspan, Alan's father, of Romanian-Jewish descent, and Alan’s mother, Rose Goldsmith, of Hungarian-Jewish descent.[1]

Greenspan is an accomplished clarinet and saxophone player who played with Stan Getz when they were in school together. He studied clarinet at the Juilliard School from 1943 to 1944, when he dropped out to join a professional jazz band.[2] He returned to college in 1945, attending New York University (NYU), where he received a B.S. in economics summa cum laude in 1948[3] and an M.A. in economics in 1950.[4] Greenspan went on to Columbia University, intending to pursue advanced economic studies, but subsequently dropped out. At Columbia, Greenspan studied economics under the tutelage of future Fed chairman Arthur Burns, who constantly warned of the dangers of inflation.[5]

In 1977, NYU awarded him a Ph.D. in economics. His dissertation is not available from NYU[6] since it was removed at Greenspan's request in 1987, when he became Chairman of the Federal Reserve Board. However, a single copy has been found, and the 'introduction includes a discussion of soaring housing prices and their effect on consumer spending; it even anticipates a bursting housing bubble'.[7]

From 1948 to 1953, Greenspan worked as an economic analyst at The Conference Board, a business and industry oriented think-tank in New York City.[citation needed] From 1955 to 1987, when he was appointed as chairman of the Federal Reserve, Greenspan was chairman and president of Townsend-Greenspan & Co., Inc., an economic consulting firm in New York City, a 33-year stint interrupted only from 1974 to 1977 by his service as Chairman of the Council of Economic Advisers under President Gerald Ford.

In the summer of 1968, Greenspan agreed to serve Richard Nixon as his coordinator on domestic policy in the nomination campaign. Greenspan has also served as a corporate director for Aluminum Company of America (Alcoa); Automatic Data Processing, Inc.; Capital Cities/ABC, Inc; General Foods, Inc; J.P. Morgan & Co., Inc; Morgan & Co., Inc.; Morgan Guaranty Trust Company of New York; Mobil Corporation; and the Pittston Company. He was a director of the Council on Foreign relations foreign policy organization between 1982 and 1988. he also served as a member of the influential Washington-based financial advisory body, the Group of Thirty, in 1984.

Chairman of the Federal Reserve

On June 2, 1987, President Reagan nominated Greenspan as a successor to Paul Volcker as chairman of the Board of Governors of the Federal Reserve, and the Senate confirmed him on August 11, 1987. After the nomination, bond markets experienced their biggest one-day drop in 5 years. Just two months after his confirmation he was faced with his first crisis — the 1987 stock market crash. Noted investor, author and commentator Jim Rogers has claimed that Greenspan lobbied to get this chairmanship.[12]

His terse statement that the Fed "affirmed today its readiness to serve as a source of liquidity to support the economic and financial system"[13][14][15] is seen by many as having been effective in helping to control the damage from that crash.

His handling of monetary policy in the run-up to the 1991 recession was criticized from the right as being excessively tight, and costing George H. W. Bush re-election. The incoming Democratic president Bill Clinton reappointed Greenspan, and kept him as a core member of his economic team. Greenspan, while still fundamentally monetarist in orientation, argued that doctrinaire application of theory was insufficiently flexible for central banks to meet emerging situations.

Another famous example of the effect of his closely parsed comments was his December 5, 1996 remark about "irrational exuberance and unduly escalating stock prices" that led Japanese stocks to fall 3.2%.[16]

During the Asian financial crisis of 1997—1998, the Federal Reserve flooded the world with dollars, and organized a bailout of Long-Term Capital Management. Some have argued that 1997-1998 represented a monetary policy bind — as the early 1970s had represented a fiscal policy bind — and that while asset inflation had crept into the United States, demanding that the Fed tighten, the Federal Reserve needed to ease liquidity in response to the capital flight from Asia. Greenspan himself noted this when he stated that the American stock market showed signs of irrationally high valuations.

In 2000, Greenspan raised interest rates several times; these actions were believed by many to have caused the bursting of the dot-com bubble. However, according to the Economist Paul Krugman "he didn't raise interest rates to curb the market's enthusiasm; he didn't even seek to impose margin requirements on stock market investors. Instead, he waited until the bubble burst, as it did in 2000, then tried to clean up the mess afterward."[17] In autumn of 2001, as a decisive reaction to September 11 attacks and the various corporate scandals which undermined the economy, the Greenspan-led Federal Reserve initiated a series of interest cuts that brought down the Federal Funds rate to 1% in 2004. His critics, notably Steve Forbes, attributed the rapid rise in commodity prices and gold to Greenspan's loose monetary policy which is causing excessive asset inflation and a weak dollar. By late 2004 the price of gold was higher than its 12-year moving average.

On May 18, 2004, Greenspan was nominated by President George W. Bush to serve for an unprecedented fifth term as chairman of the Federal Reserve. He was previously appointed to the post by Presidents Ronald Reagan, George H. W. Bush and Bill Clinton.

In a May 2005 speech, Greenspan stated: "Two years ago at this conference I argued that the growing array of derivatives and the related application of more-sophisticated methods for measuring and managing risks had been key factors underlying the remarkable resilience of the banking system, which had recently shrugged off severe shocks to the economy and the financial system. At the same time, I indicated some concerns about the risks associated with derivatives, including the risks posed by concentration in certain derivatives markets, notably the over-the-counter (OTC) markets for U.S. dollar interest rate options."[18]

Greenspan's term as a member of the Board ended on January 31, 2006, and Ben Bernanke was confirmed as his successor.


In the early 1950s, Greenspan began an association with famed novelist and philosopher Ayn Rand that would last until her death in 1982.[23] Rand stood beside him at his 1974 swearing-in as Chair of the Council of Economic Advisers.[23]

Greenspan was introduced to Ayn Rand by his first wife, Joan Mitchell. Although Greenspan was initially a logical positivist,[31] he was converted to Rand's philosophy of Objectivism by her associate Nathaniel Branden. During the 1950s and 1960s Greenspan was a proponent of Objectivism, writing articles for Objectivist newsletters and contributing several essays for Rand's 1966 book Capitalism: the Unknown Ideal including an essay supporting the gold standard.[32][33]

During the 1950s, Greenspan was one of the members of Ayn Rand's inner circle, the Ayn Rand Collective, who read Atlas Shrugged while it was being written. Rand nicknamed Greenspan "the undertaker" because of his penchant for dark clothing and reserved demeanor. Although Greenspan was once recognized as a proponent of laissez-faire capitalism, some Objectivists find his support for a gold standard somewhat incongruous or dubious,[citation needed] given the Federal Reserve's role in America's fiat money system and endogenous inflation. He has come under criticism from Harry Binswanger,[34] who believes his actions while at work for the Federal Reserve and his publicly expressed opinions on other issues show abandonment of Objectivist and free market principles. However, when questioned in relation to this, he has said that in a democratic society individuals have to make compromises with each other over conflicting ideas of how money should be handled. He said he himself had to make such compromises, because he believes that "we did extremely well" without a central bank and with a gold standard.[35] Greenspan and Rand maintained a close relationship until her death in 1982.[23]

In a congressional hearing on October 23, 2008 Greenspan admitted that his free-market ideology shunning certain regulations was flawed.[36] However, when asked about free markets and the ideas of Ayn Rand in an interview on April 4, 2010, Greenspan clarified his stance on laissez faire capitalism and asserted that in a democratic society there could be no better alternative. He stated that the errors that were made stemmed not from the principle, but the application of competitive markets in "assuming what the nature of risks would be."[37]

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Analysis by the Blog Author

The flawed free market ideology was demonstrated back in 1998, when Greenspan orchestrated the bailout of Long Term Capital Management, putting the foot of the Federal Reserve in the door of derivatives organizations on their behalf (see the Timeline). This bias was further shown in his furious opposition to Brooksley Born and the CFTC, who wanted all derivatives traded on exchanges with legal and reserve requirements (also on the Timeline in 1998). Greenspan's opposition to making derivatives accountable was fully supported by then Treasury Secretary Robert Rubin, who had very close ties to large banks.

How can a renaissance man like Alan Greenspan, who once played the saxophone with young Stan Getz (it doesn't get any better than that!) and who knew a bestselling author for decades, make such a blunder?

The answer is simple but chilling. Greenspan could not imagine bankers making such a big blunder. Bankers, he reasoned, would not take needless risks with the depositors' capital. They could be counted on to seek to make money rather than to engage in gambling. The valuation method won a Nobel Prize. Banks were using state of the art methods and computerized iterations to provide an additional service to their corporate customers, effectively underwriting insurance contracts in the form of derivatives. In a free society, citizens can be counted on to act in their own rational self interest.

Certainly this is how Greenspan felt. He even complimented derivatives in a congressional hearing in May of 2005 for reducing risk. The contracts were spread among many buyers and many sellers and hedged by opposing contracts. The banks were counterparties (effectively underwriters) in a relatively neutral position. It would take an almost impossible shift of opinion and circumstances, a black swan, for the banks to be wrong. Let the banks do it. It's a simple laissez-faire situation and a clear, almost instantaneous ideologically easy decision.

But the line of reasoning he used was dead wrong.

In real world situations, realism trumps idealism (see list 1 of post 1 of this blog and the preference for realism, philosophically).

Computer iterations are not data, not lab findings, nor the results of titrations. They are pawns spawned by the programming of the computer. As we have seen, this is extraordinarily compact and complex programming that is itself difficult to edit. We can be even simpler: "garbage in, garbage out" iterations lulled the bankers and their risk committees into thinking that taking both sides of a derivatives met made them neutral and therefore their fees as counterparties were "free money."

Emotionally and intellectually, Greenspan wanted to believe that high tech new banking instruments were a tool of the good for further prosperity. This is the cue for the spirit of Cognitive Bias to enter, singing a sweet tune of a Siren [another dangerous sisterhood of Greek goddesses].

The derivative instruments were changing all the time, becoming legally and economically more complex so that they would be broader and result in higher fees. So the fact that derivatives did not result in a lasting crash in the 1980s probably convinced Greenspan that they didn't need to be regulated or constricted in the 1990s, and no broad crash had occurred, in spite of a catastrophic drop in the NASDAQ in 2000, through the end of Greenspan's long term.

Greenspan had a long and honorable career. He was blessed by the company of ingenious persons, including significant artists like Stan Getz and Ayn Rand, as well as brilliant thinkers and researchers like Arthur Burns. His consulting firm was a success, based especially on his sturdy prediction in 1960 that whether Richard Nixon or John Kennedy won the presidency, big government was going to grow significantly in the coming decade. He never sought to use the power of the federal reserve system to create an economic problem with political consequences for the president in power, be it Ronald Reagan, the senior Bush, William Clinton or George "W" Bush. Greenspan played fair regardless of any agreement or disagreement with the philosophy of the current President under which he served.

Greenspan was an honorable man of significant personal artistic skill and philosophical integrity.


He never bothered to look at another side of human nature. He was not associated with bunko artists, con men, wheeler dealers or any other sort of riff-raff in his long career. He certainly never understood the personal ambitions of a politically motivated economics PhD like Phil Gramm.  He had never been an auditor nor a prosecutor.  I have no evidence that he consulted any during his tenure as chairman of the Federal Reserve. 

We can tell from his continued defense of derivatives as late as 2005 that he never understood the potential for misuse, for wheedling organizations into offering insurance outside their line of business specialty, for the absolute, bone-hard requirement that insurance providers, re-insurers and underwriters maintain reserves, a truth plain and simple for all the state-level governing insurance boards.

So, Greenspan pushed through federal law favoring quasi-insurance without any reserve requirements; these are insurance bets that are immune to state insurance laws, as the bill was crafted by Senator Gramm. Reasonable, responsible capitalistic decision makers can be trusted not to endanger themselves, he figured.

The honest banking capitalists didn't understand their own rapidly evolving financial instruments. The dishonest ones wanted large commissions. They also insured that banks spent more and more on lobbyists, so that if things went sour, they would be bailed out of they were too important to the economy.

Thus was Greenspan strangled by the over-simplifications of his own ideology. Unlike the other players in this tragedy, he recalculated his assumptions and apologized for being wrong once things went wrong and the market tanked.

Meanwhile, the bets are still on the table, totalling 20 times the GDP of the world and supported by no reserves whatsoever. More than half of these bets are traded privately rather than on an exchange, effectively completely unregulated.

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